An Overview of Buy-Sell Agreements

Portland Buy - Sell Agreements Lawyer

Beaverton Shareholder Interests Attorney

There are three types of buy-sell agreements. The first is a cross-purchase agreement. It provides for the purchase of a decedent shareholder’s stock by the surviving shareholders. In most instances, each shareholder owns insurance on the other shareholders in an amount that will fund the acquisition of stock in the event that a shareholder dies.

Cross-purchase agreements can become complicated if there are many shareholders with varied interests, especially if there are disparities in the ages and insurability of the shareholders. Cross-purchase agreements, therefore, work best when there are a limited number of shareholders that are around the same age, and who hold relatively equal numbers of shares.

The second type, a stock redemption agreement, provides for the purchase of the stock of a withdrawing shareholder by the corporation itself. This purchase may also be funded by insurance. The principal advantages of stock redemption agreements are cost and versatility. Insurance policies are often not required because the corporation acquires the stock and the cost of the repurchase is not born by the shareholders themselves. They are versatile because they can be created in situations where the shareholders are of varying ages and may not be able to acquire insurance on one another.

The third type, hybrid agreements, is the most commonly used buy-sell agreement. They combine elements of both cross-purchase and stock redemption agreements. Hybrids give the corporation the option to buy the withdrawing shareholder’s stock; however, if the corporation is unwilling or unable to do so, the option will pass to the remaining shareholders to the extent not exercised by the corporation.

Hybrids usually provide that the corporation and/or the remaining shareholders must purchase all of the stock. If the stock is not completely acquired by the corporation and the shareholders, the withdrawing shareholder is free to sell the stock to an outside buyer. Oregon statutory law has two requirements in order for the corporation to acquire the stock. First, it may only do so if, once acquired, the business is still able to pay its debts as they become due. Second, the total assets of the corporation must be at least equal to the amount of the corporation’s liabilities plus the amount needed to satisfy any obligation the corporation has to holders of senior classes of stock, in the event that the corporation is dissolved.

Events Triggering Stock Acquisition
A shareholder or partner may leave an organization voluntarily or involuntarily. To eliminate potential conflict between remaining shareholders and departing shareholders or their estates, shares will be transferred according to the terms of the buy-sell agreement. The following are some triggering events that can be provided for ahead of time.

  1. Lifetime Transfers
    Buy-sell agreements contain provisions that give the corporation or the shareholders (or both) either a first right of refusal or an option to acquire the stock in the event that a shareholder withdraws from the corporation. A first right of refusal requires a withdrawing shareholder to find a third-party buyer for the stock. The corporation and the remaining shareholders are then given the right to match the offer. This may inhibit the shareholder from finding a willing buyer, however, because the third party will understand that the purchase is contingent upon others’ rights.

    The selling shareholder often would prefer to exercise an option. Here, the shareholder first offers to sell the stock to the corporation or remaining shareholders for a specified price and terms. If they choose not to buy the stock, the shareholder may then sell to a third party for a price and terms no more favorable than those offered to the corporation.
  2. Death
    When a shareholder dies, the corporation or remaining shareholders may be given the option to purchase the decedent shareholder’s stock. The agreement may require the corporation to redeem all or part of the stock, so the corporation may want to obtain life insurance on its shareholders in order to pay for the stock. Of course, the stock must be purchased for a fair price in order to avoid lawsuits by the shareholder’s estate.
  3. Bankruptcy, disability and divorce
    The remaining shareholders may be able to acquire the stock from a bankrupt shareholder. It is unclear if the remaining shareholders can enforce this option against the trustee in bankruptcy. This depends on whether the trustee can invalidate the buy-sell agreement under bankruptcy law.

    A shareholder’s disability should not be considered in a buy-sell agreement unless the corporation has sufficient liquidity to cover the expense of purchasing the disabled shareholder’s shares. Consider purchasing disability insurance to cover key shareholders in the event that one becomes disabled.

    Generally, divorce is not a triggering event. A court will rarely award corporate stock to the non-participant spouse.
  4. Dual Shareholders
    Where there are only two shareholders of the corporation or partnership and each one owns 50% of the stock, and one wishes to withdraw, a "Solomon’s Choice" provision forces the remaining shareholder to buy the stock. If the remaining shareholder does not buy the stock, the agreement will often require that the remaining shareholder sell his or her stock to the departing shareholder. This is a clever way to prevent an impasse between the two shareholders, but should be entered into only upon careful consideration, since disparate financial means between the shareholders may lead to unanticipated problems in fairness.

Placement of Restrictions
The shareholders must be given notice of any restrictions placed upon the transferability of the corporate stock. There are three places where the shareholders may locate the notice: the articles of incorporation, the bylaws, or in the shareholder’s agreement itself.

Although the articles of incorporation or the bylaws may contain the required notice of restrictions, separate agreements should be drafted clarifying the terms of price, valuation, triggering events and other provisions. The agreement may also address issues such as insurance coverage and the rights of selling stockholders during the payment period. Restrictions on transferability must be noted conspicuously on the front or back of the stock certificate, or, in the case of stock that is issued without certificates, contained in the information statement about the stock. If the restrictions are not listed in this manner, they will not be effective.

If the restrictions on transferability are contained in the articles of incorporation or bylaws, it would unduly complicate the two documents and could only be changed through an amendment of the articles or the bylaws, which is time consuming. The best option is to place the restrictions of stock transfer in a separate agreement generally titled "shareholders’ agreement," "stock redemption agreement," "stock purchase agreement," "buy-sell agreement," or "buyout agreement."

Valuation
The most essential term in a buy-sell agreement is the price of the stock. Valuation of the stock can be determined in one of four ways. First, the corporation or remaining shareholders can pay the book value of the shares at the time of death, or at the end of the corporation’s next accounting period. Second, a price may be fixed in the buy-sell agreement itself. Frequent revisiting and revaluation is required under this method in order to ensure that the price remains fair. Third, the corporation can have the stock appraised and the price fixed after death, but this method is costly and time consuming. Fourth, the corporation may use one of several self-adjusting formulas.

There are several other terms that should be clarified in the buy-sell agreement. If the purchase will take place over a period of time, the agreement should address the interest rate applicable to the installment sale. If an installment sale is contemplated, the agreement should address whether there is to be a security agreement between the parties so that the shareholders or their estates will enjoy a security interest in the remaining balance owed.

Summary
It is of critical import to examine potential tax consequences and consider each shareholder’s personal estate planning goals. But having a clear, well-written buy-sell agreement is essential for all closely held corporations and partnerships. These agreements allow for a smooth transition during difficult times, such as the death or departure of a key shareholder.

Transferring corporate stock according to the terms of an agreement written by corporate counsel is both certain and cost-effective. Moreover, utilizing buy-sell agreements is the best way to ensure that corporate stock will stay in the hands of the shareholders.

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